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Saturday, January 26, 2013

The risk-free rate

I just did a Google search for “risk-free rate.” It seems there’s this idea that the risk-free rate is some “theoretical” rate. I think there is, in fact, a close enough risk-free rate, which is a rate that is actually attainable risk-free, and that there is also a theoretical risk-free rate (what the rate should be) which may be significantly different than the close enough to risk-free rate. This theoretical rate shouldn’t be used to actually value investments, though, and that’s the risk-free rate I’m interested in here: the rate to use to value investments. A theoretical rate doesn’t allow me to determine the return that I can achieve, or should require, given a level of risk, and if I have cash to invest, I’m not really concerned with what minimum rate I should require on a risk-free asset. I need to begin with what is actually available. The goal is to determine the rate of return an investor should expect among the available investment options. Theoretical rates don’t go very far in the real world.

Let’s look at an example of why I don’t care what the risk-free rate should be. Assume that I have a bill that needs to be paid in 3 months, but I have the cash today. I can do 1 of 3 things:

I can pay the bill today.

I can hold the cash and pay the bill in 3 months.

I can invest the cash at the risk-free rate and then pay the bill in 3 months.

Whether the risk-free rate is as high as it should be, the best alternative is number 3. It doesn’t matter whether I was properly compensated for the time value of my money because in both of the other cases, I won’t be compensated at all.

Offhand, at least for my purposes, I don’t really see much value in knowing what the risk-free rate should be. However, if you’re interested, you can read up on the subject here.

One thing is for sure: the Fed is manipulating the risk-free rate, and it is without a doubt lower than it should be. Knowing that doesn’t do me any good in evaluating investment options though.

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